GE & Mark to Market

For more than a decade General Electric Co. could easily avoid disclosing the value of its real estate and business loans. Not any more.

Since Jan. 2, GE has lost 45 percent on the New York Stock Exchange, mostly because shareholders are no longer willing to accept whatever the Fairfield, Connecticut-based company tells them about its finance subsidiary unless it’s based on so-called mark-to-market accounting rules.

The world’s biggest maker of jet engines and power turbines told shareholders last week that 2 percent of GE Capital Corp.’s assets are being valued based on market prices. The remaining $624 billion is being carried at levels that GE, the last original member of the Dow Jones Industrial Average, established in many cases years ago, according to CreditSights Inc.

“The notion of having 98 percent opaque and 2 percent valued with clarity is something that by its very nature would make investors nervous,” said Robert Arnott, founder of Research Affiliates LLC, which oversees $30 billion in Newport Beach, California and owned 481,201 GE shares as of Dec. 31. “Having some clarity on what the other 98 percent is worth is valuable.”

98% valued at fantasy prices, 2% at real world prices means that there is nothing but trouble down the road for GE.

Federal Reserve Chairman Ben S. Bernanke said today that he wouldn’t support any suspension of mark-to-market accounting.

Once the world’s largest company, with a market value of almost $600 billion, GE has plummeted to $93.7 billion in New York Stock Exchange trading. The shares posted two of the three worst weekly declines since 1980 during the past month as investors speculate the deepest financial crisis since the Great Depression will cause more writedowns and losses at its finance division than the $10 billion the company anticipates.

GAAP Accounting

Last week, the stock fell below $6, the price of some GE light bulbs, for the first time since 1991. Today, GE jumped 20 percent to $8.87 after its finance unit sold $8 billion of government-backed debt.

“We have significantly increased transparency and disclosure,” GE spokesman Russell Wilkerson said in an e-mailed response to questions, pointing to a two-hour meeting the company had with analysts and investors in December to review GE Capital’s business. Still, “we recognize there is a need and an opportunity to do more.”

GE, which will hold a five-hour meeting with investors and analysts on March 19 to discuss the finance unit’s business, follows generally accepted accounting principles, which don’t require it to mark all assets to market, according to Wilkerson. In fact, the rules in many cases forbid it, he said.

GE Capital Forecast

GE predicts the finance unit will earn $5 billion this year, more than forecasts by analysts surveyed by Bloomberg. Goldman Sachs Group Inc. analyst Terry Darling in New York expects the finance unit to break even this year as losses from loan losses swell in commercial real estate and in Eastern Europe.

GE’s forecast reserves relative to loans of 2.5 percent this year are still “thin” relative to banks, which means raising more capital is “inevitable,” according to Darling.

The gap between GE and the analysts reflects differing valuations for assets in the finance division.

The unit is similar in size to the sixth-biggest U.S. bank, according to an estimate by CreditSights, an independent bond research firm based in New York. Most of its loans are senior secured debt tied to assets such as aircraft.

GE Capital generated 48 percent of the parent company’s $18.1 billion in profit last year. That compares with about 20 percent in the late 1980s, according to Nicholas P. Heymann, an analyst at Sterne Agee, a Birmingham, Alabama-based brokerage.

Differing Realities

He estimated in a note on March 3 that GE may need more money to cover losses of between $21 billion to $54 billion in the next several years. That would be almost as much as Merrill Lynch & Co. wrote down, according to data compiled by Bloomberg. New York-based Merrill was acquired by Bank of America Corp. of Charlotte, North Carolina.

Heymann’s “analysis is flawed and produces misleading estimates,” GE’s Wilkerson said. Heymann applies a historical loss rate of 2.5 percent for banks to GE’s real-estate equity holdings as well as its loans, leading to loss estimates that are twice as large as they should be, according to GE’s Wilkerson.

“The transparency is what you want,” said Barry James, chief executive officer of James Investment Research Inc. in Xenia, Ohio, which oversees $1.3 billion. “I don’t think anybody knows what they’re worth.”

‘Needlessly Destructive’

The debate over the fair-value rule, which requires companies to assess assets every quarter to reflect a market price, divides finance industry executives.

Banks say the rule, also known as mark to market, requires them to report losses from falling values even if they don’t expect to incur penalties because the assets aren’t for sale. The lower valuations can force companies to raise capital to comply with federal regulations.

Blackstone Group LP Chairman Stephen Schwarzman, the American Bankers Association and 65 lawmakers in the House of Representatives urged that fair-value accounting, mandated by the Financial Accounting Standards Board, be suspended last September. William Isaac, chairman of the Federal Deposit Insurance Corp. from 1981 to 1985, has called fair value “extremely and needlessly destructive” and “a major cause” of the credit crisis. Robert Rubin, the former Citigroup Inc. senior counselor and Treasury secretary, said Jan. 27 the rule has done “a great deal of damage.”

Fed Chairman Bernanke told Congress Feb. 25 that fair value is a “good principle in general” even if accounting rulemakers have to “figure out how to deal with some of these assets” that aren’t actively traded.

Today, the central bank chief in remarks prepared for an address to the Council on Foreign Relations in Washington added that he wouldn’t support suspending fair value accounting, saying “I strongly endorse the basic proposition of mark-to-market.”

Securities and Exchange Commission Chairman Mary Schapiro has said mark to market wasn’t a significant factor in the current crisis.

Blaming the rule “is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick,” Dane Mott, an analyst at JPMorgan Chase & Co., wrote in a September report.

This is 100% correct. Anyone who suggests that mark to market is a significant factor or cause of the crisis has no idea what he is talking about. William Isaacs statement is almost comical. Fair value is “extremely and unnecassarily destructive”? What is that supposed to mean? It is bad management and producing losses that is extremely and unnecessarily destructive, why would reporting the results of it be? If anything, getting the right reporting gives the managers in charge the ability to change course before it’s too late. Mark to market is in fact the solution, not the cause of the credit crisis.

GE, which may lose its AAA ratings from Moody’s Investors Service and Standard & Poor’s, will meet with analysts this month to make good on Chief Financial Officer Keith Sherin’s promise of a “deep dive” explanation of the finance unit. The company cut its dividend for the first time since 1938 last month to preserve $9 billion in cash.

“Investors need the assets broken down so they can see what’s really there,” said Craig Hester, president of Hester Capital Management, which oversees about $1.1 billion in Austin, Texas. “The market cares about whether GE is being honest. In the case of GE, there is fear.”

In theory, mark-to-market provides good information for potential investors and prevents businesses from assigning any value they choose — likely a higher one — to things they own.

But mark-to-market can cripple businesses when no market for an asset exists, like now.

Big banks are struggling to survive — shares of Citigroup, once the world’s largest bank, closed at $1.02 today — because their balance sheets are poisoned with assets for which no market exists. Chiefly, the mortgage-backed securities based on lousy mortgages. No one wants to buy them right now, so that means no market exists.

Some day, there will be a market for those securities. But until there is, banks have to account for them at fire-sale prices, and that’s what’s making the banks sick.

If no market exists for an asset, it means that nobody wants to buy it. If nobody wants to buy it its price needs to be lowered. If nobody wants to buy it at any price its price is $0.00. Whether or not a business holds assets that are worth $0.00 versus $1,000,000 is something that an investor might want to know about if he commits his own money. Who can possibly support the view that lying to investors is a good thing?

What it most concerning about this whole debate on mark to market is that its main premise seems to be that we currently have mark to market accounting in place. Then why does GE only have 2% of its assets marked to market? Why does Citigroup still have $800 billion in overvalued SIVs? The problem is precisely that accounting rules currently enable businesses to try and trick the public by not pricing their assets fairly. President Obama himself implicitly called for mark to market accounting. When will we see any of it materialize?